Truemors
A Critical Essay in Five Parts
In the first of this series of articles, we explored the importance that trust has in the success of our monetary systems and we used a bank card as both a metaphor for the money supply and as a symbol of our own personal wealth. Continuing with these themes is useful in reasoning out what happened during the recent local bank crisis. There are several types of banks; but, the local one, as opposed to the Bear, Stearns & Co. failure, was a bank that had private depositors.
When we borrow money from a bank we consider ourselves in debt, likewise when we deposit money into a bank debt also occurs, only this time the bank is in debt to us. We pay back our loans and they honour our cheques and when we insert our bank cards into the ugly teller machines money comes out, thus establishing trust. Since we are rational beings we know that a piece of plastic or a book full of little slips of paper are not the real wealth but symbols of the wealth that we control. But, since everyone else is playing this little game and we have developed a relationship of trust, coupled with years of experience that this system works, we are happy enough to go along. Only deep down we know that banks are in the business of giving our money away in the hopes that they will make a profit, and experience tells us that for the most part they are competent at this. We trust them.
Banks make their profits by loaning out money, they know that there are people out there who want cash so bad that they will pay extra just to get their hands on it. The only problem standing in the banks' way is that they don't have any money of their own, so they borrow it from us. We loan the banks our cash, for say 3% interest, and they take it because they know people who will pay 4% to acquire it. This is how the dollar dance begins. Cash money, or M1, is a lot of things to a lot of people; but, one thing that it is not is stationary. Like any long-haul trucker or taxi driver will tell you, they don't make money standing still. Neither does cash. As fast as we bring our money in through the front door of a bank it is sent out again, on loan. The more they have to loan the more profit they make. Simple.
A conservative bank may lend out 80% of the money their customers have deposited in personal accounts. The balance being reserved for cash and cheque transactions, money transfers to other banks, and customer withdrawals. With the onset of credit cards, electronic transfers, direct debits and the rolling over of long term retirement plans, banks began to realise that only 5% of their cash reserves were needed day-to-day for actual physical exchanges. As much as 15% of the money in their control was sitting on the shelves collecting dust! They correctly figured that by lending out this money they could increase their profits by 18.75% with little or no risk. Since borrowing money on credit has become so easy in recent years banks found that even though every penny available was out on loan there were still people willing to borrow more if the bank could only get their hands on some.
Not only do banks borrow from us they borrow from other larger banks at a discount rate which enables them to make a little more profit. After this bank to bank borrowing, with each one taking their little cut, goes on for a while two things can happen, interest rates can rise to slow the pace and money becomes scarce, or the Central Banks can expand the money supply simply by printing new notes. If the supply of money became scarce this would curtail the amount of loans and thus profits the bankers were hoping to make!
Money is a commodity, it is governed by the laws of supply and demand, just like any of the other marketable goods. In the rush for profits in a fast growing economy some banks may lend out not only the 5% reserve mentioned previously but money not even under their control. How can they do this? Have you ever had to wait "5 working days" for a cheque to "clear" from one bank to the other? Now you get the idea. If cash standing still makes no profit; but money on the move brings in revenue, then that suggests the faster you move the money around the greater the profit you can make. When money gets scarce these lending institutions may raise the 5 working days for a cheque to clear to seven or ten or beyond, these banks have a cash flow problem and hopefully for the account holder it is only temporary.
If any bank takes risks like these sometimes they are going to have short falls, losses, or write offs to contend with. These could be minor hiccups or full scale blunders with long lasting effects. If the depositors of the bank in trouble lose their confidence and trust in the bank's ability to handle their finances they will hardly be likely to stand around happy with a fistfull of plastic cards. At this point they don't want a symbol of their wealth they want the wealth itself, no more playing games, "show me the money", then there is a run on the bank for the money held captive by the financial institution. If enough depositors withdraw their cash the bank will collapse, no retail bank is immune to this, and luckily another source of revenue was injected to stop the panic, this time.
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